The 83(b) Election: Why Pay Tax on Something You Didn’t Earn or Sell?
What is 83(b)?
As the title implies, it’s an IRS code section that typically applies to Stock Awards made to corporate executives, stock grants for startup founders, and some stock option recipients. The key issue with this election is that the stock award (or other compensation) must have strings attached – for example, the stock may have a 4-year vesting schedule or performance requirements before it can be earned and sold.
Once the 83(b) election is made, you pay ordinary income tax on the value of the stock award on the grant date (instead of the vesting date), and you also start the clock running on the long-term capital gains tax treatment of future gains.
A Simplified Example
As a newly hired executive, you were awarded 10,000 shares of restricted stock valued at $1/share to vest in 3 years. The company then went public 3 years later and the shares traded at $35. If you had made the election, you would have included $10,000 as taxable income in the year of the grant, but no taxes would have been due in year 3 when you owned stock worth $350,000. If you later decided to sell the stock, you would owe capital gains taxes on the $34/share appreciation.
If the election was not made, you would not owe taxes the year of the grant, but in year 3 you would have additional W2 income of $350,000 to pay at ordinary tax rates!
There are several rules that make this a very delicate decision. The 83(b) election cannot be reversed once it is made, and the election must be made within 30 days of the stock award (or other compensation grant). Also if the stock is forfeited or maybe just drops to $.01/share, you still owe taxes based on the original grant date value.
Why 83(b) is more important today?
With the 3.8% surtax and expiration of the Bush tax cuts expected in 2013, now is the time to consider bringing income into 2012 at lower rates. For high income taxpayers, moving assets that would be subject to ordinary tax rates (35%+) to capital gains rates (20%) also makes a lot of sense.
Takeaways on the 83(b) Election
- It should not be taken lightly since the decision is irrevocable and involves significant tax implications.
- It helps control the timing and amount of tax owed since you know when and how much compensation will be taxable if you make the election.
- Consider it if there is a high likelihood the stock will stay at the same price or grow significantly.
- Avoid the election if the stock is extremely risky or volatile, or if your future job security may be in question.